Lagging valuations, lengthy time frames keep secondaries from becoming routine, say GPs

The audience at a recent industry event got an unusual perspective on continuation fund deals, this time from GPs who have been through the process.

I found their views instructive, especially as they related their experiences to regular M&A processes. The overarching point was that, until some of the more inefficient aspects of the continuation fund process are smoothed out, these deals aren’t likely to become routine exit options alongside IPOs and strategic sales.

The length of time it takes to reach a final close, and the asset valuations associated with “reference dates” that can lag by six months or more, are two factors that limit more frequent use of the strategy, one of the GPs said. The event was considered “on background,” so I’m not using the GPs’ names.

“I’m excited to watch as this whole product evolves, it benefits a lot of parties,” one of the GPs said. “It also has some quirks to it, like the valuations, that will need to evolve over time if it’s going to continue taking market share or continue to take dealflow away from traditional sponsor-to-sponsor or IPO exits or strategic sales.”

GP-led continuation fund deals involving one or multiple assets have become a popular method of PE firms delivering liquidity to LPs in older funds, while keeping hold of treasured investments.

GP-led deals accounted for around 35 percent of total deal flow in the first half, with about $50 billion of activity, according to PJT Park Hill’s first-half secondaries volume survey. This “technology” in the industry vernacular took off several years ago and reached its peak of popularity in 2021.

But after leading deal activity for the first time, buyers’ desire for such deals faded as they shifted focus to capturing greater asset diversification through LP portfolio sales and away from the concentration that comes with single- or several-asset deals.

More recently, activity around GP-led processes has picked up, with a deal pipeline that has been characterized as robust. A major limiting factor in opening up this side of the market is simply a lack of capital, sources have said in past interviews.

While popular among GPs, such deals are complex and complicated to get done, meaning that they may not ever reach the point where they are considered a legitimate third exit option along with IPOs or sales to strategic acquirers or other PE shops.

One of the more inefficient parts of the process derives from continuation funds’ secondaries heritage: pegging asset values to a price as of a specific “reference date” that is usually three to six months prior to the closing of the deal, the GPs said.

The valuation inflexibility differs from regular M&A processes and doesn’t allow these deals to account for material changes in operations or in the broader economy, one of the GPs said at the recent event.

“That was where I really had to intellectually get my mind and heart around to understand that, despite the good or bad performance over the next time period, it really didn’t matter that much,” one of the GPs said.

The other challenging aspect of the process is length of time. Continuation fund deals routinely take six months or more to reach final close. A key to shortening this process would be to surface as many questions as possible early on, not to mention achieving buy-in from the impacted LP bases.

“I think the playbook is more about education, and looking at what the common elements are to a deal, and being prepared before going into a deal. Think about why you are doing it, the rationale for the continuation vehicle… At least come up with questions you should be asking yourself to be prepared coming into a deal.”

LPs are obviously a major factor in the process and, even in the most LP-friendly of deals, may still present an obstacle to reaching final close. “If you’re creating that amount of agita even for a small group, you really have to think hard,” one of the GPs said.

Project management is essential in running an efficient process because of the number of people involved, which pretty much hits most of a firm’s operations, including investor relations, deal execution, marketing, legal and accounting. “There’s so many people involved, mapping out who is doing what, and more frequent communications… that would have helped facilitate the deal,” one of the GPs said.